Increase In Default Risk Research Articles

Another Dark Side of IRR - Excessive Leverage, Increased Default Risk and Wealth Destruction

The internal rate of return (IRR) is still a widespread criterion for investment decisions, although many pitfalls are well known. This paper provides evidence for another, more fundamental, dark side of IRR: Based on a dynamic model of optimal capital structure with endogenous bankruptcy trigger and risk-adjusted yield of debt we show that capital structures maximizing IRR are suboptimal, i.e., not value maximizing. The IRR criterion triggers the choice of higher leverage increasing the risk of default. Depending on the parameter setting the net benefit of financing reduces by up to 50 per cent. As optimizing the financing structure based on IRR is popular in PE related settings, our results are especially important for this industry.

The Cost of Stock Trading to Firms

I study the effects of stock trading costs into a dynamic corporate finance model with financing frictions. When trading entails a cost, the issuing firm needs to pay an illiquidity premium to shareholders, which increases the firm's cost of capital and the opportunity cost of cash. The illiquidity premium leads to a decrease in the firm's target cash, exacerbates financial constraints, increases default risk, and reduces firm value. This firm's response can feed back into trading costs and amplify their real effects. The model warns of some consequences of regulatory restrictions on trading in financial markets.

Equity Investor Sentiment and Bond Market Reaction: Test of Overinvestment and Capital Flow Hypotheses

This paper examines the effect of equity investor sentiment on the bond market. While empirical evidence suggests that high investor sentiment leads to equity overvaluation, there is limited evidence of its effect on the bond market. Sentiment can have a negative impact on bond returns via two channels. First, in times of high investor sentiment, overvalued equity can lead to firm overinvestment, resulting in a negative impact on bond pricing due to an increase in default risk. Second, overvalued equity attracts capital flow to the equity market from the bond market which can create a downward pressure on bond pricing. Consistent with these channels, I find that equity investor sentiment exhibits a significant negative relation with contemporaneous bond returns; this effect is stronger for the sample of firms with overinvestment. In distinguishing the effects of the two channels, I find a positive relation between sentiment and subsequent bond returns, consistent with a return reversal predicted by the capital flow channel (due to the backflow of capital); however, there is no return reversal observed for the overinvestment sample, indicating that overinvestment has a more lasting impact. Additionally, I find a negative (but delayed) impact of equity investor sentiment on bond ratings for the overinvestment sample consistent with an increase in default risk of these firms. Overall, my study highlights that behavioral biases in the equity market do not automatically get transmitted to the bond market. In fact, the bond market reacts negatively to sentiment-induced overinvestment in a rational way, consistent with bond investors' payoff function. In addition, the results indicate a potential role of investor sentiment in explaining the decoupling relation between the stock and bond markets.

Do Short Sellers Exploit Industry Information?

This study provides new evidence that short sellers have superior skills in processing industry information. In industries with the highest aggregate shorted values, the most-shorted stocks earn –2.76% abnormal returns over the next six months. These results are likely driven by short sellers’ preference for complex industries with the highest profit potential. In the targeted industries, firm-level shorting predicts an increase in default risk, suggesting that short sellers successfully identify firms with fundamental problems. Overall, our results suggest that short sellers help to reduce information complexity and improve economic efficiency at the industry level.

The Impact of High Microfinance Growth on Loan Portfolio

AbstractMost empirical studies in microfinance have disproportionately focused on its downstream effects—effects on the borrower—leaving the important question of how microfinance institutions are affected in the process, largely unanswered—upstream effects. This paper addresses this question by using panel data estimations to empirically investigate the causal effect of microfinance growth on microfinance institution loan portfolio quality. Surprisingly, we find evidence that portfolio quality improves with growth in outreach, which is contrary to the dominant view that higher growth leads to increased default risk. This result is robust across estimation methods and even after controlling for microfinance institutional characteristics and macroeconomic indicators. Copyright © 2015 John Wiley & Sons, Ltd.

The Role of Dispersed Information in Pricing Default: Evidence from the Great Recession

The recent Global Games literature makes important predictions on how financial crises unfold. We test the empirical relevance of these theories by analyzing how dispersed information affects banks' default risk. We find evidence that precise information acts as a coordination device which reduces creditors' willingness to roll over debt to a bank, thus increasing both its default risk and its vulnerability to changes in expectations. We establish two new results. First, given an unfavorable median forecast, less dispersed beliefs greatly increase default risk; this is consistent with incomplete information models that rely on coordination risk while in contrast with a wide range of models that neglect this component. Second, less dispersion of beliefs amplifies the reaction of default risk to changes in market expectations; importantly, precise information raises banks' vulnerability by more than standard measures of banks' fragility. Taken together, our results suggest that enhanced transparency, by providing agents with more precise information, increases banks' vulnerability to changes in sentiment and raises the default risk of weaker banks. Finally, we address concerns of endogeneity of market expectations by introducing a novel set of instruments.

An analysis of default risk in the Home Equity Conversion Mortgage (HECM) program

While reverse mortgages are intended as a tool to enable financial security for older homeowners, in 2014, nearly 12 percent of reverse mortgage borrowers in the federally insured Home Equity Conversion Mortgage (HECM) program were in default on their property taxes or homeowners insurance. Unlike the traditional mortgage market, there were no risk-based underwriting guidelines for HECMs through 2014. In response to the relatively high default rate, a variety of policy responses were implemented, including establishing underwriting guidelines. However, there is a lack of data and analysis to inform such criteria. Our analysis follows 30,000 seniors counseled for reverse mortgages between 2006 and 2011. The data includes comprehensive financial and credit report attributes, not typically available in analyses of reverse mortgage borrowers. Using a bivariate probit model that accounts for selection, we estimate the likelihood of tax and insurance default. Financial characteristics that increase default risk include the percentage of funds withdrawn in the first month of the loan, a lower credit score, higher property tax to income ratio, low or no unused revolving credit, and a history of being past due on mortgage payments or having a tax lien on the property. Our estimate of the elasticity of default with respect to credit scores is similar to that for closed-end home equity loans, but higher than that for HELOCs. We simulate the effects of alternative underwriting criteria and policy changes on the probability of take-up and default. Reductions in the default rate with a minimal effect on participation can be achieved by requiring that participants with low credit scores set aside some of their HECM funds for future property tax and insurance payments, a form of escrowing.

On the Effectiveness of Capital Requirements

This paper investigates the effectiveness of capital requirements in reducing the default risk of portfolio-managing financial intermediaries. It is shown that the effectiveness depends, in essence, on the risk preferences of the intermediary and market conditions. The central result is that any binding capital requirement with risk weights not proportional to expected excess returns will prompt any sufficiently risk tolerant intermediary to increase default risk. The paper analyses the interplay between investment risk and default risk and identifies regulatory as well as market conditions under which financial intermediaries increase their default risk when facing binding capital requirements. It is shown how inappropriately chosen capital coefficients may increase rather than decrease the default risk of a financial intermediary.

Financial Crises, Debt Financing, and Default Risks

We examine the mechanism through which a financial crisis affects the default risk of real economy firms. We find that firms with strong dependence on bank financing suffer from higher increases in default risk than firms with no such dependence. Conversely, firms that rely solely on financing from public debt markets do not experience significant increases in default risk. We also find that the increase in default probabilities, caused by a decrease in bank lending, is only significant for firms with low credit quality. These findings suggest that the bank supply shock theory helps explain the transmission channel of shocks from the financial sector to the real economy. Finally, firms dependent on bank financing cannot completely offset adverse impacts stemming from supply shocks in bank lending by substituting bank loans with publicly traded debt.

The Role of Dispersed Information in Pricing Default: Evidence from the Great Recession

The recent Global Games literature makes important predictions on how financial crises unfold. We test the empirical relevance of these theories by analyzing how dispersed information affects banks' default risk. We find evidence that precise information acts as a coordination device which reduces creditors' willingness to roll over debt to a bank, thus increasing both its default risk and its vulnerability to changes in expectations. We establish two new results. First, given an unfavorable median forecast, less dispersed beliefs greatly increase default risk; this is consistent with incomplete information models that rely on coordination risk while in contrast with a wide range of models that neglect this component. Second, less dispersion of beliefs amplifies the reaction of default risk to changes in market expectations; importantly, precise information raises banks' vulnerability by more than standard measures of banks' fragility. Taken together, our results suggest that enhanced transparency, by providing agents with more precise information, increases banks' vulnerability to changes in sentiment and raises the default risk of weaker banks. Finally, we address concerns of endogeneity of market expectations by introducing a novel set of instruments.

Who Are the Losers of IFRS Adoption in Europe? An Empirical Examination of the Cash Flow Effect of Increased Disclosure

Unlike prior studies that examine the denominator effect, this study investigates the cash flow effect of disclosure as captured by firms exhibiting increases in default risk (DR) around the 2005 mandatory International Financial Reporting Standards (IFRS) adoption in Europe. Using the Merton (1973, 1974) option-based probability of default measure (DR) on a data set of 415 winner firms (with decreases in DR) and 295 loser firms (with increases in DR), we show that loser firms exhibit the same or better financial characteristics in the pre-IFRS adoption period compared with the winner sample. However, after IFRS, loser firms exhibit deteriorating characteristics, with smaller increases in their Tobin’s q valuations, greater increases in leverage, and poorer return performance. Logistic analysis suggests that even though in the pre-IFRS period loser firms exhibit greater profitability and analyst following and lower leverage, in the post-IFRS period their profitability is less than that of winner firms while exhibiting similar leverage and analyst following characteristics. Through an examination of the determinants of the change in DR, the results suggest that loser firms incur a greater increase in DR the poorer their home country’s legal enforcement environment, the lower their analyst following, and the greater their propensity to manage earnings. In general, our results are consistent with the existence of a significant cash flow effect for the loser sample.

Bank Interest Margin and Default Risk under Basel III Capped Capital Adequacy Accord and Regulatory Deposit Insurance Fund Protection

We study the optimal bank interest margin and default risk under the capped ratio schedule of government capital instruments in the Basel III Capital Adequacy Accord and the Deposit Insurance Fund arrangement program. We show that an increase in the capped ratio (a decrease in the capped government capital injection) increases the default risk in the bank’s equity return at a reduced interest margin. Regulatory deposit insurance fund protection reinforces the reduced bank interest margin and the increased default risk. The capped ratio schedule as well as the fund protection program makes the bank more prone to loan risk-taking, thereby adversely affecting the stability of banking system. This paper suggests that the two means of government intervention in response to the recent financial crisis might be not appropriate for a bank in distress, particularly from the standpoint of bank failure.

Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage

Although the direct effect of lender-of-last-resort (LOLR) facilities is to forestall the default of financial firms that lose funding liquidity, an indirect effect is to allow these firms to minimize deleveraging sales of illiquid assets. This unintended consequence of LOLR facilities manifests itself as excess illiquid leverage in the financial sector, can make future liquidity shortfalls more likely, and can lead to an increase in default risks. Furthermore, this increase in default risk can occur despite the fact that the combination of LOLR facilities and reduced asset sales raises the prices of illiquid assets. The behavior of U.S. broker-dealers during the crisis of 2007–09 is consistent with this unintended consequence. In particular, given the Federal Reserve’s LOLR facilities, broker-dealers could afford to try to wait out the crisis. Although they did reduce traditional measures of leverage to varying degrees, they failed to reduce sufficiently their illiquid leverage, which contributed to their failures or near failures. Several mechanisms to address this unintended consequence of LOLR facilities are proposed.

Bank Supply Shocks and Default Risk

We examine the mechanism through which a financial crisis affects the default risk of real economy firms. Specifically, firms with strong dependence on bank financing suffer higher increases in default risk than firms with no such dependence. Conversely, firms relying solely on financing from public-debt markets do not experience significant increases in default risk. These findings suggest that the bank supply shock theory helps to understand the transmission channel of shocks from the financial sector to the real economy. Finally, bank-dependent firms cannot completely offset adverse impacts stemming from bank-lending supply shocks by substituting bank loans with publicly traded debts.

An Analysis of Default Risk in the Home Equity Conversion Mortgage (HECM) Program

While reverse mortgages are intended as a tool to enable financial security for older homeowners, in 2014, nearly 12 percent of reverse mortgage borrowers in the federally insured Home Equity Conversion Mortgage (HECM) program were in default on their property taxes or homeowners insurance. Unlike the traditional mortgage market, there were no risk-based underwriting guidelines for HECMs through 2014. In response to the relatively high default rate, a variety of policy responses were implemented, including establishing underwriting guidelines. However, there is a lack of data and analysis to inform such criteria. Our analysis follows 30,000 seniors counseled for reverse mortgages between 2006 and 2011. The data includes comprehensive financial and credit report attributes, not typically available in analyses of reverse mortgage borrowers. Using a bivariate probit model that accounts for selection, we estimate the likelihood of tax and insurance default. Financial characteristics that increase default risk include the percentage of funds withdrawn in the first month of the loan, a lower credit score, higher property tax to income ratio, low or no unused revolving credit, and a history of being past due on mortgage payments or having a tax lien on the property. Our estimate of the elasticity of default with respect to credit scores is similar to that for closed-end home equity loans, but higher than that for HELOCs. We simulate the effects of alternative underwriting criteria and policy changes on the probability of take-up and default. Reductions in the default rate with a minimal effect on participation can be achieved by requiring that participants with low credit scores set aside some of their HECM funds for future property tax and insurance payments, a form of escrowing.

A Journey into the Dark Arts of Quantitative Finance

A Journey into the Dark Arts of Quantitative Finance

The Use of ABX Derivatives in Credit Crisis Litigation

In this article, we focus on the ABX indices, explain their economic functions, and explore how these indices are currently used in litigation related to the credit crisis. The ABX indices reflect important information for market participants, but a full understanding of the economics behind the indices is critical. Simple arguments and approaches about how the ABX indices should be used are bound to be flawed. The indices are meant as a publicly available measure of investors’ perception of the subprime market and their expectations about the expected defaults of the underlying mortgage collateral. But as the crisis unfolded and liquidity declined and even disappeared at various points, from not just the subprime market but all markets, the levels of the ABX indices reflected not just the increased default risk on the underlying referenced mortgages but also the increased perception of risk, lack of liquidity, increased uncertainty, and significant changes in the macroeconomic environment. It is critical to conduct careful analysis of the components of these ABX derivatives to properly use them as inputs in valuation.

Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage

While the direct effect of lender-of-last-resort (LOLR) facilities is to forestall the default of financial firms that lose funding liquidity, an indirect effect is to allow these firms to minimize deleveraging sales of illiquid assets. This unintended consequence of LOLR facilities manifests itself as excess illiquid leverage in the financial sector, can make future liquidity shortfalls more likely, and can lead to an increase in default risks. Furthermore, this increase in default risk can occur despite the fact that the combination of LOLR facilities and reduced asset sales raises the prices of illiquid assets. The behavior of U.S. broker-dealers during the crisis of 2007-2009 is consistent with the unintended consequence just described. In particular, given the Federal Reserve's LOLR facilities, broker-dealers could afford to try to wait out the crisis. While they did reduce traditional measures of leverage to varying degrees, they failed to reduce sufficiently their illiquid leverage, which contributed to their failures or near failures. Several mechanisms to address this unintended consequence of LOLR facilities are proposed: condition LOLR access and terms on the financial health of borrowers; condition LOLR access and terms on asset sales and deleveraging; and, especially, instead of supporting troubled financial firms, open LOLR facilities to financially sound, potential buyers of illiquid assets.

An international comparison of the causes of changes in the debt service ratio 1980-1985

The forces leading up to the debt crisis of the 1980s go back a long way. As a country experiences a rising ratio of debt service payments to export earnings so its default risk increases. World indicators show that interest rates were on a rising trend when commodity prices were on a downward trend. However, this is a simplistic analysis. The authors disaggregate the ratio into five components: a change in the volume of debt; a change in the rate of amortisation; a change in the rate of interest; a change in the volume of exports; a change in the price of exports. The article examines these independently in the light of the available data. Results suggest that rescheduling policy is uncoordinated and that debt-management methods can be improved.

Does Bank Default Risk Increase with Information Asymmetry? Evidence from Europe

We analyze the impact of information asymmetry on bank default risk in Europe from 1993 to 2011 and show that banks that are more difficult to value by investors are characterized by a higher default risk. The risk-increasing effect of information asymmetry is present both before and during the global financial crisis but the drivers of this effect differ in the two periods. In the years preceding the crisis, information asymmetry leads to an increase in default risk via excessive risk-taking by banks; during the crisis it determines an increase in default risk through a larger exposure of banks to shocks. The excessive risk-taking by informationally opaque banks before the crisis is higher in large banks but the exposure to shocks during the crisis is larger in small informationally opaque banks. Our results highlight the macro-prudential benefits of rules on bank transparency and the importance of applying these rules also to smaller banks.